The Impact of SOX on Earnings Management Activities around CEO Turnovers

Abstract

We assess the impact of the Sarbanes-Oxley Act (SOX) on discretionary accruals (DA) and real earnings management (REM) activities around CEO turnovers. Improved corporate governance post-SOX can either deter earnings management (the deterrence effect) or pressure CEOs to inflate earnings when facing imminent turnover risks (the pressure effect). We find a strong deterrence effect for new CEOs, while the pressure effect dominates the deterrence effect for outgoing CEOs. Pre-SOX firms with new CEOs manage earnings downward through both DA and REM and the effect is more pronounced in weakly governed firms. Post-SOX both types of earnings baths diminished. By contrast, post-SOX firms engage in more aggressive upward earnings management prior to CEO turnovers and the evidence is stronger prior to performance-induced CEO turnovers. The compulsory compliance with the 2003 NYSE and NASDAQ listing rule on audit committee independence is associated with a reduction in new-CEO REM baths.